Investors everywhere struggle with the same question. It’s pertinent whether your portfolio is way up or way down.
How do I know when to sell stocks? There’s no single answer. And there are many schools of thought.
Back in October, our former Editor-in-Chief Andy Snyder wrote a thought-provoking column on the importance of an exit strategy. As he pointed out, not even The Oxford Club sticks to a single doctrine on when to sell stocks. Different editors use different strategies for different portfolios.
Let’s go over some of the most successful methods of determining when to sell stocks. As we’ll learn, each one has its pros and cons.
As we’ve written before, using trailing stops is a popular strategy that allows investors to sell automatically when it becomes clear that a stock is going south.
Our Chief Investment Strategist Alexander Green recommends trailing stops on most of his portfolios (though not all).
In short, the idea is to set a maximum percent loss (typically 25%).
If a stock dips below that percent loss, your trailing stop kicks in and sells the stock automatically.
This isn’t just a method to determine when to sell stocks – it’s also a great insurance policy.
If you allocate your assets cautiously, you won’t have more than 4% of your entire portfolio in any single stock. If you protect that portfolio with 25% trailing stops, then you can’t lose more than 1% of your portfolio at any given time.
However, there are certain situations in which trailing stops are an overzealous or redundant exit strategy. For one thing, not all trading platforms offer instant trailing stops. Also, they may sell out during a large (but recoverable) dip, which could cause you to miss out on future growth.
And finally, if you’re more of a fund-investing person, some managers already use trailing stops within their funds. It’s a powerful strategy, but not necessarily a universal one.
There’s another way to determine when to sell stocks that is much simpler. Some investors recommend drawing up a set of criteria that must be met for you to keep holding a stock. If a particular investment stops meeting all of your holding criteria, then off it goes.
This is the method that our Chief Income Strategist Marc Lichtenfeld recommends for his 10-11-12 System. If a stock doesn’t keep increasing its dividend, Marc sells it. It’s a fantastic strategy for income investors and those who prefer reliable blue chip stocks.
But for growth and value investors who like to make riskier bets, the “holding criteria” method may be too rigid. Small caps and cheap stocks tend to undergo a lot of flux on their way to high returns. For these underpriced stocks, you may want to use some variant of the third method.
This is perhaps the most widely accepted way to determine when to sell stocks. But it’s also the most complex.
Why do we buy stocks? Because we think they could be worth more than they are now. Unless you’re a dividend investor like Marc, you buy shares of a company because you think it’s undervalued relative to its future size.
Thus, one very logical way to determine when to sell is by setting a price target. In other words, you figure out when your stocks hit their correct value and sell them there.
There are a number of ways to set a price target. But one of the simplest uses price-to-earnings (P/E) ratios. You may recognize these from our Stock Grader series. They’re an indicator of undervaluation or overvaluation of a company relative to its competitors. And you can calculate them easily – just divide a stock’s price by its annual earnings per share.
Using a P/E strategy is pretty simple. You buy a stock with a lower P/E than those of its competitors, and you sell when that stock’s P/E matches or exceeds its competitors’. This method is useful because it protects you from getting caught in the collapse of an overvalued stock or sector bubble.
But like all of these strategies, it’s not perfect. Emerging Trends Strategist Matthew Carr has pointed out that P/E is a backward-facing metric. The stock’s performance and earnings over the past year may not indicate its future performance. And forward P/E is calculated using analysts’ earnings forecasts, which may be wrong.
In sum, there’s no foolproof way to know when to sell stocks. You should use different methods for different investments. If you’re angling for growth, trailing stops may be your best bet. If you’re a dividend investor, use holding criteria. And if you’re looking for value, then price targeting may be the way to go.
No matter which method you choose, just make sure you have an exit strategy. You’ll need it eventually, whether your portfolio does very well or very poorly.
— Samuel Taube
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Source: Investment U